Well Below Expectations

Good Evening: The bad news finally caught up with the markets today. For weeks investors have been trying to shrug off the poor economic data and earnings misses in the hopes that such news was already “priced in” to the market. Even in recent days, when worries about the future started to furrow some brows in Wall Street, no market decline had the type of scary credentials (e.g. down 4% to 5% in one day) common to so many trading days in 2008. Even the VIX refused to budge very much, indicating a lack of any real fright. These attitudes changed today, and the resulting damage has left investors wondering if the November lows will soon be at risk.

Most of the major averages in Asia were actually up last night, but Wednesday’s first bad surprise came from Europe in the form of a huge loss reported by Deutsche Bank. The loss was, to set the theme for the rest of the day, well below expectations. U.S. stock index futures were down between 1% and 2% when the December retail sales figures came out prior to the open. Sales fell 2.7% last month (-3.1% ex-autos), a disappointment that was more than twice as large as had been expected. Import and export prices both fell markedly, and perhaps some of these price drops reflected discounts for Nortel’s products (which entered Chapter 11 — an event few foresaw happening this month). Business inventories fell 0.7% in November but sales fell even faster, leading to a fairly large spike in the sales to inventory ratio. A report estimating that housing still has a lot further to fall only added to the growing sense of unease (see below).

Market participants didn’t like these stories any more than they enjoyed the news flow in December, but today they decided to do something about it. That something amounted to a flurry of sell orders at the open, and the major averages dropped 3% within minutes. Less than an hour later, many indexes were down 4% to 5%, and the VIX index jumped back over the 50 mark for the first time since mid December. The rest of the day was spent digesting this lower than expected market action, but the rally attempts never managed to recoup even half the losses. Another visit to the lows late in the day was followed by another weak rally into the bell, leaving the averages down between 3% (Dow) and almost 5% (Dow Transports). As one might expect, Treasurys were sought and yields dropped between 3 bps and 12 bps across the coupon curve. As for credit, some sectors (high quality corporates) held in well, while a friend from the up and coming high yield department at Jeffries tells me bonds in his universe were under some pressure. As for the dollar, it benefited from the turmoil and rose 0.2%. Commodities tried to follow stocks to the downside, but it’s tough to fall very far when you jump out of a first floor window. The CRB index retreated just more than 1% today.

So why is the bad news starting to matter now? After all, we’ve been seeing similar stories for weeks without seeing a big down day in the markets. The difference today has to do with expectations. Investors knew that once credit seized up last fall that the Q4 data would be bad; it’s just that they didn’t think it would be this bad. Another possible explanation comes in the form of new worries about the banking system. Whether it is Deutsche Bank this morning or Citibank over the weekend, few expected the banks to be back in the soup so quickly after all the bailout packages were rushed into place last fall (see below). To put it kindly, the never-ending troubles at the banks are very much below investors’ expectations.

The turning point, in terms of the share prices for financial firms, came last week when Oppenheimer’s Meredith Whitney announced more trouble lay ahead for the banks. Slightly less famous, but just as accurate about the troubles facing our nation’s financial institutions, Deutsche Bank analyst, Mike Mayo, made a case similar to one made by Ms. Whitney in a fairly detailed report of his own. Entitled, “Issue in 2009 is loan losses”, Mr. Mayo’s forecast came out at least one day prior to the one made by the esteemed Oppenheimer analyst. It’s a long and detailed report, but the short version is the same one I posited earlier this month. The losses banks reported in 2007 and 2008 were mostly the result of bad investments residing on the balance sheet (i.e. structured mortgage paper, leveraged loans, exposure to Lehman, etc.). The losses banks face in 2009, however, will come from good old-fashioned loan losses — the type that have always hit the banks during recessions. That Citi, even after huge handouts from Uncle Sam, still needs to raise capital is a cautionary tale for the rest of the banks in 2009. The prospect of having to again bail out the financial system after they thought the problem was “solved” simply scares investors, and they’ve been selling equities ever since Mr. Mayo’s report came out. The only way to invest in this type of environment is to stay liquid, stay with quality, and stay away from financial stocks. With that said, if the S&P 500 can continue to hold above the 820 to 840 area on a closing basis, then we might see a bounce into next week’s inauguration. If not, the November lows are indeed at risk.

— Jack McHugh

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